Conflicts of interests: avoid or disclose?
CONFLICTS OF INTERESTS – AVOID OR DISCLOSE?
At first sight, the rules governing conflicts of interests in the financial sector are rather straightforward and easy to apprehend. As long as there is a duty of loyalty or care owed, service providers need to put the interests of their clients first (and treat them fairly and equally). Hence, service providers must avoid conflicts between their own interests and their clients’ interests. If a conflict arises, they must yield and give priority to their clients.
But rules also generally say “avoid or disclose”. The idea is that you should not have conflicts of interests, but if you do then you must disclose them to your clients. Or is it that conflicts of interests are acceptable as long as they are disclosed? It’s all in the “or”…
Fees
Fees are a typical area of conflicts. Some financial intermediaries receive retrocessions or commissions from other actors in the market in relation with the services provided to their clients.
For example, investment advisers have arrangements with mutual funds where they receive compensation (sometimes over 1% of the invested assets) in return for buying shares of those funds on behalf of their clients. This compensation is meant to cover distribution and marketing costs and is paid by the fund (therefore the investors) to the “distributors”.
In the case of investment advisers or asset managers however, such tasks of marketing or distribution are not really completed. Advisers manage their clients’ assets (with or without discretion) and in that context select funds for them. Clients generally pay an assets under management fee which covers the analysis and selection of all investments (including funds). A retrocession from these funds is therefore basically an extra income for no additional work performed. On the other hand, if clients were to buy the same shares through another “distributor” (e.g. broker or bank), these fees would be paid indirectly by the clients. But does that justify that an adviser not really acting as a distributor is allowed to keep that income? Many countries have restricted or even outlawed such practices, but if it is within the applicable legal framework, why not?
In the US, such fees (“12b-1 fees” paid to dually registered broker-dealers, capped at 1%) are allowed as long as the client is informed that the adviser receives compensation for selecting certain (share classes of) funds and that, should it be the case, lower cost share classes of the same funds were available.
In the EU, MiFID II basically requires that advisers automatically pass on all such fees to their clients. And in Switzerland, these retrocessions must be declared to the client who then decides if the adviser can keep them, otherwise they belong to the client.
If you are an investment adviser, you have an interest to buy (or recommend) the shares of the funds that provide you with a kickback rather than other funds. This is a non negligible additional revenue to the one you already receive for managing the client’s assets. But you also have a duty to act in the best interests of your clients, whether called fiduciary, loyalty, care or diligence. According to that duty, and the resulting best execution rules, when selecting a fund for your client, receiving additional compensation should not be one of your criteria. Also, once you have selected a fund, you should buy the share class that is most advantageous to your client.
So is it still acceptable to receive such compensation creating a conflict between your and your clients’ interests? The SEC says it is, as long as that conflict is clearly disclosed (without using the term “may”). The American regulator has even recently created the Share Class Selection Disclosure Initiative which allows investment advisers to come forward and self report to the SEC if they (or their related entities and individuals) have received 12b-1 fees in the past without disclosing it properly to their clients. As already mentioned, the EU and Switzerland are more stringent and only Swiss advisers may keep the fee if the client accepts after being duly informed.
The concept of disclosing in order to keep the fee, and thereby potentially putting the adviser’s interest over the client’s, seems contradictory to the fiduciary or loyalty duty itself and best execution rules. As an adviser, can you prove that this fund and that share class were the best choice for your client although you received an additional remuneration for selecting it? Do you have the adequate and available records showing the selection process and rationale? Advisers should make sure they can answer these questions.
While many advisers understand that plain double dipping is not acceptable and offset the fees when they put funds that they (or their affiliates) manage into their advisory clients’ portfolios, they still do receive distribution fees from third-party funds. They just disclose it in their ADV Brochures if registered in the US, or in contracts or other documents addressed to clients.
Not just regulatory compliance, but also marketing strategy
The client-adviser relationship is largely based on trust. If you are a client and you are informed that your adviser receives additional income by choosing certain investments for you over others, how high will your level of trust rate? Advisers need to ask themselves if those side revenues are worth it in terms of client acquisition and retention, in addition to potential dispute.
It certainly is an odd feeling to read an adviser’s brochure that basically says: for an all-inclusive fee, we will manage your money and try to add value to it by selecting the best investments for you. Except when an investment can bring us extra income, then we probably will select that one, even if it is not the best for you. So please read the prospectus and expense ratio of any fund we put in your portfolio and draw your own conclusions.
In the end the current system does leave it to clients. In the US, if you are a client you are informed that basically your adviser recommends a fund because there is a financial incentive for him to do so, and therefore the advice you receive is not necessarily for your own good – but you can always select another adviser that chooses not to receive such income. In Switzerland, you are entitled to receive the fee but you rely on the adviser to inform you and pass it on to you.
The fiduciary duty provides an alternative to avoiding a conflict by disclosing it. Best execution however implies that the adviser must select the best fund and the best share class for the client. Swiss and US advisers may keep the retrocessions under the appropriate disclosures, but they still must be able to prove the suitability and appropriateness of the investment for the client, and it is not always easy to justify an investment decision made months ago. Keeping the retrocessions requires a strong investment selection process (well organized and documented), appropriate disclosures and great trust from your clients. Only that can lead to an investment that has all the qualities: suitability to the client profile and additional income for the adviser.
March 2019